Collateral Legal Meaning: Everything You Need to Know
Collateral legal meaning is any item of value that has been pledged to guarantee loan repayment.3 min read
2. Common types of collateral include:
3. Credit Reputation
4. Understanding How Assets are Valued
Collateral legal meaning is any item of value that has been pledged to guarantee loan repayment. It refers to assets (signed over by a borrower) that a lender uses to secure a loan. Once the borrower defaults on the agreed upon loan repayment schedule, the lender could sell off some or all of the assets to satisfy the loaned amount. If you have signed over an asset as collateral to a lender, such an asset cannot be sold without the lender's consent.
Secure and Unsecured Loans
Once you have repaid the loan in full, the collateral is yours to do with as you wish since the lender has no claim over it. When compared to unsecured loans, loans with collateral attached usually have lower interest rates since the borrower offers a form of security to the lender in the event of a default in the loan repayment schedule. A lien refers to the lender's claim on the collateral offered by a borrower.
Lenders require collateral because it is a guarantee that the money loaned will be repaid even if the borrower is unable to make payments on the loan. As such, most lenders work with collateral that can easily and quickly be liquidated, i.e., sold for cash. This means that lenders are less likely to accept collateral items that can't easily be sold.
Common types of collateral include:
- Insurance policies
Generally, items or property used for collateral are of significant value; however, they can vary depending on the circumstances of the borrower as well as the policies of the lending institutions. The value of the collateral is not calculated based on the prevailing market rate. The value is discounted based on what will be lost if the asset is liquidated to satisfy the loan.
Unlike secured loans where borrowing businesses must put up assets as insurance that loans will be repaid, unsecured loans rely on the strength of the borrower's credit score. Businesses with a long history of operational success may be eligible for unsecured loans, i.e., loans without collateral. On the other hand, it is almost certain that small businesses that wish to expand or new enterprises will have to secure loans with collateral.
Once the borrower defaults, the bank can assume ownership of the assets put up as collateral. Depending on their needs, whether making or executing expansion plans, or going through a financial crunch, businesses can resort to different kinds of collateral arrangements.
Understanding How Assets are Valued
Business owners and lenders often view the worth of assets differently. In most cases, businesses view assets based on its cost, current value, the extent of usage and the upper end of the market's prevailing rate. On the other hand, lenders take a somewhat pessimistic and more cautious view of the value of the asset. There is always a cost to the termination of a loan agreement before the stipulated time frame, particularly in cases where the borrower can no longer make the required loan payments. Understanding this cost will enable you to see reasons why the value of your assets as calculated by the lender is usually lesser than expected.
Lenders usually offer you about 50-90 percent of the value of the asset being used as collateral, though the percentage could be lower depending on the kind of asset and lending institution. For instance, if you use investment portfolio as collateral, lenders may only offer 50 percent of its value, due to the volatile nature of the investment.
The value of such investments can decrease during the loan's tenure. When you borrow against your home (i.e., home equity), lenders provide you with up to 80 percent of your home's loan-to-value ratio (LTV). When using cars as collateral, you may be offered 25-50 percent of the car's value.
Before taking a loan that requires a collateral, you must carry out due diligence and be extra careful to ensure the affordability of the repayments. You must be aware that some types of secured loans can be riskier than others. Carry out thorough research, shop around and ensure that you stick to the repayment schedule to avoid losing your asset.
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